Monday, January 27, 2014

The way to limit systemic risk in the financial system is to limit leverage. Everything else is pretty much a distraction. This isn't to say that other things, prosecuting insider trading, fraud, other ethical violation, etc, aren't important, but they just don't have much to to with systemic risk.

FLG has been calling for hard, fast rules limiting leverage because, well, he wants to limit leverage (see above). He also thinks things like the Volcker Rule sound great in theory become horrible 2,400 pages of indecipherable mess that can and will be gamed when all is said and done. Far better to just set up a rule that can be both explained and actually implemented in one sentence. So, you can imagine FLG's joy when he read this the other day:

It's particularly tenet-shaking because of the blunt arbitrariness of the rules: Lending to companies with a debt-to-earnings (no, debt to our good friend Ebitda, earnings before interest, taxes, depreciation and amortization) ratio of greater than 6 times is basically right out, but a 5.9x ratio is fine. Give or take.1 You can buy a company and lever it more than 6 times, but not with (any) bank debt. You gotta go get bonds, and "Since bonds are typically more expensive than loans, the revised structure can make the deals more costly."

It's pure, simple, and easily understood leverage limiting. Sure, this arbitrary rule will create some inefficiencies, but almost any regulation will create inefficiencies.